Image: Watersnood 1953
A terrible storm hit the Dutch coast in February 1953, busting the sea dikes that had protected the Netherlands for longer than anyone could remember. The tragic flooding killed more than 1,800 people, and it served as a wake-up call to the entire country and to hydrologists in particular.
It was unimaginable before it happened, but the water level reached nearly 4 meters above the normal level in the coastal towns. Researchers soon found that a 4-meter flood had taken place in the late 1500s as well. Because everyone felt safe on account of the dikes, no one expected this disaster. Yet the Dutch people didn’t debate the fine points when the disaster occurred; instead they dealt with the damage and constructed the world famous Deltawerken – a piece of infrastructure that still stands.
Image: Deltawerken
In "The (Mis)behavior of Markets," author Benoit Mandelbrot used it as an example. It really struck a chord with me because my grandfather lived in nearby Zeeland and decided to go and help in the aftermath.
Adding to the death toll, another 100,000 people were left homeless. Small wonder the event is embedded in the national consciousness, given the enormity of the tragedy. The photographic record is astounding, but it’s the sad images of so many deceased cows littering the landscape that have stuck in my mind’s eye.
Mandelbrot used the Dutch flood primarily as an analogy to the errors he saw in the world of finance:
Such pragmatism is needed in financial theory. It is the Hippocratic Oath to "do no harm." In finance, I believe the conventional models and their more recent "fixes" violate that oath. They are not merely wrong; they are dangerously wrong. They are like a shipbuilder who assumes that gales are rare and hurricanes myth so he builds his vessel for speed, capacity and comfort –Â giving little thought to stability and strength. To launch such a ship across the ocean in typhoon season is to do serious harm. Like the weather, markets are turbulent. We must learn to recognize that and better cope.
Mandelbrot points to several models that he sees as dangerous and names Black-Scholes, Modern Portfolio Theory, Efficient Market Hypothesis and Capital Asset Pricing as prime bad examples. Author Nassim Taleb shares this view and likens these models to explorers who depend upon random maps.
Rewind to 1953: The Dutch felt secure in the knowledge their dikes would always protect them from every storm; similarly, we believe if our portfolio is adequately diversified, we’ll ride out any downturns. According to Mandelbrot, this is a sort of fairy tale.
The author proposed a new model, the Multifractal Model of Asset Returns, which he believed more closely reflects how markets really work. He offered helpful and useful “rules” although they won’t help you pick specific stocks. Instead, he explained how dangerous leverage can be and how the market can drop by 25% to 50% within a very short time frame. His work suggested resisting the temptation to optimize your portfolio for maximum return.
Mandelbrot’s new model can be summarized like this:
The multifractal model successfully predicts what the data show: that at short time frames prices vary wildly, and at longer time frames they start to settle down.
Ever since Benjamin Graham first described the value investment style, notable value investors have given advice that dovetails beautifully with Mandelbrot's. Here are just a few illustrations:
"I learned that if I can simply survive in the market, just like surviving in the war, and not lose money, eventually I will make something."Â – Walter Schloss
"So one way to create an attractive risk/reward situation is to limit downside risk severely by investing in situations that have a large margin of safety. The upside, while still difficult to quantify, will usually take care of itself. In other words, look down, not up, when making your initial investment decision. If you don't lose money, most of the remaining alternatives are good ones."Â – Joel Greenblatt (Trades, Portfolio), "You Can Be a Stock Market Genius"
"People should be highly skeptical of anyone's, including their own, ability to predict the future and instead pursue strategies that can survive whatever may occur."Â – Seth Klarman (Trades, Portfolio)
"When people talk about sigmas in terms of disaster probabilities in markets, they're crazy. They think probabilities in markets are Gaussian distributions because it's easy to compute and teach, but if you think Gaussian distributions apply to markets, then you must believe in the tooth fairy. It reminds me of when I asked a doctor at a medical school why he was still teaching an outdated procedure, and he replied, 'It's easier to teach.'"Â –Â Charlie Munger (Trades, Portfolio) (May 2007)
If the Dutch people had the benefit of this type of thinking back in 1953, they would put survival at the forefront and building bigger dykes would have saved many.
Mathematics aren’t my strong suit, but I got a lot out of this book nonetheless. "The (Mis)Behavior of Markets: A Fractal View of Risk, Ruin and Reward" will cause readers to view the market in a new light and may very well help them to avoid financial ruin.
